From Monday's blog in StockMarketCookBook.com:
Condors of the feathered kind may be on the endangered species list but condors of the stock derivative kind are alive and well. One in full plumage was spotted over the Isle of Capri (NASDAQ:ISLE), a gaming concern with operations in Mid-America, Florida, England, and the Bahamas. This condor is of the iron variety, and no, it is not a 70’s heavy metal band.
What is an iron condor and how is it used?
An iron condor is an options combination that is the sane person’s version of a credit strangle. A credit strangle is a neutral options strategy. It’s put on when the investor feels that the price of the underlying stock (or future) will stay within a certain range before options expiration. The strangle involves selling an equal number of out-of-the-money (OTM) calls with an equal number of OTM puts. The problem with this strategy is that if the unexpected happens (as it tends to do) and the stock zooms past either strike price, losses begin mounting quickly as options are leveraged instruments.
Options are also extremely versatile giving us a saner way to make a similar bet. In this case, that way would be the iron condor which is a covered version of the credit strangle. It consists of a bull-put credit spread where the higher strike put is sold and the lower strike put is purchased and a bear-call credit spread where the lower strike call is sold and the higher strike one is bought. The strike prices in both spreads are the same distance apart.
Novice options traders may find this confusing (and as always, please don’t try this or any other options strategy until you thoroughly understand it and have paper traded it), but the following example should clarify how it works.
ISLE stock trading in a range
The Isle of Capri (ISLE) has been trading in a zone between $11.50 and $14 for the past several months. Conflicting coverage may have something to do with the stock’s constrained movement. For example, on July 22 Zacks gave the company its highest rating say that the it crushed analyst estimates and earnings consensus is up sharply for the next year while on the very same day the Motley Fool published a completely opposing view giving the company its lowest rating. No wonder investors are confused!
Continued confusion means that the stock could be range-bound for a while making it a perfect candidate for a neutral options strategy. Let’s look at how an iron condor would work on the Isle of Capri.
The Isle of Capri Iron Condor Strategy
The options field for ISLE isn’t terribly robust. When I write options, I like to write them for the shortest time possible but in this case I’m going to have to look out to October where there’s decent open interest. One good thing, though, about writing farther term options in a market of declining volatility is that I will have collected some excess premium on top of declining theta (time value).
Using Monday’s options prices (since that’s all I have to work with at the moment), here are the calculations for an October iron condor combo on ISLE:
October Bear-Call Credit:
Buy 17.50 Call @ $0.20
Sell 15 Call @ $0.55
Credit = $0.35
October Bull-Put Credit:
Buy 10 Put @ $0.60
Sell 12.50 Put @ $1.55
Credit = $0.95
Total Credit (Reward): $0.95 + $0.35 = $1.30 (not including commissions & fees)
Max. Risk: Difference in option strike prices – Total Credit = $2.50 - $1.30 = $1.20
Lower Break-even point: Strike price of sold put – Total Credit = $12.50 - $1.30 = $11.20
Upper Break-even point: Strike price of sold call + Total Credit = $15 + $1.30 = $16.30
Profit is realized if the stock price is between the break-even points at options expiration. However, since expiration is a ways away and anything can happen during that time, what I would do (and have done in the past) is to close out a leg when the difference between the two options prices are very low, say less than $0.10. For the call spread, this will happen when the stock price nears its channeling low around $11.50, and for the put spread, this will happen when the stock nears its channeling high of $14. Whatever you do, make sure to close out both options on each side simultaneously (that is, don’t leg out of it) as you DO NOT want to be left with an uncovered options position.
The risk/reward for this strategy is very attractive, although the commission costs are high. For this reason, it’s recommended to go with a deep-discount broker if you intend to make a lot of butterfly and condor plays.
Disclosure: No positions